Question

How to explain price stability in the context of quantity theory of money and neutrality? Consider the Fisher effect and discuss its relation with the real interest rate.

Answer 1

According to quantity theory of money and neutrality, price level doubles with the increase in the quantity of money in the economy. This means the price stability has direct relationship. This means that for the same amount of goods and services consumer has to pay the double amount. The price stability is proportional to money supply in the economy.

According to fisher effects,

Real interest rate = nominal interest rate - expected inflation rate

This means that real interest rates Decrease when there is increase in inflation rate unless nominal interest rate will be same as rate of inflation